QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2009

or

¨

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from to
.

Commission file number: 000-23265

SALIX PHARMACEUTICALS, LTD.

(Exact name of Registrant as specified in its
charter)

Delaware

94-3267443

(State or other jurisdiction of

incorporation or organization)

(I.R.S. Employer

Identification No.)

1700 Perimeter Park Drive

Morrisville, North Carolina 27560

(Address of principal executive offices,
including zip code)

(919) 862-1000

(Registrants telephone number, including area code)

Indicate by check mark whether
the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports),
and (2) has been subject to such filing requirements for the past 90 days. YES x NO ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File
required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such
files). YES ¨ NO ¨

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of large accelerated filer,
accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act.

Large accelerated filer

¨

Accelerated filer

x

Non-accelerated filer

¨ (Do not check if a smaller reporting company)

Smaller reporting company

¨

Indicate by check mark whether registrant is a shell company (as defined in Rule 12b-2 of the
Exchange Act). YES ¨ NO x

The number of shares of the Registrants Common Stock outstanding as of August 7, 2009 was 48,823,905.

Cost of products sold (excluding amortization of product rights and intangibles of $2,501 and $2,271 for the three-month periods ended
June 30, 2009 and 2008, and $5,003 and $4,542 for the six-month periods ended June 30, 2009 and 2008, respectively)

11,411

7,114

21,316

14,370

Fees and costs related to license agreements

500

105

500

1,605

Amortization of product rights and intangible assets

2,501

2,271

5,003

4,542

Research and development

22,837

15,358

42,911

41,256

Selling, general and administrative

28,995

22,967

54,010

44,144

Total cost and expenses

66,244

47,815

123,740

105,917

Income (loss) from operations

(14,010

)

(6,744

)

(26,732

)

(30,592

)

Interest income (expense) and other income, net

(1,354

)

149

(2,645

)

610

Income (loss) before provision for income tax

(15,364

)

(6,595

)

(29,377

)

(29,982

)

Provision for income tax

47

(494

)

94

(1,104

)

Net income (loss)

$

(15,317

)

$

(7,089

)

$

(29,283

)

$

(31,086

)

Net income (loss) per share, basic

$

(0.32

)

$

(0.15

)

$

(0.61

)

$

(0.65

)

Net income (loss) per share, diluted

$

(0.32

)

$

(0.15

)

$

(0.61

)

$

(0.65

)

Shares used in computing net income (loss) per share, basic

48,240

47,763

48,175

47,743

Shares used in computing net income (loss) per share, diluted

48,240

47,763

48,175

47,743

The accompanying notes are an integral part of these financial statements.

Salix
Pharmaceuticals, Ltd., a Delaware corporation (Salix or the Company), is a specialty pharmaceutical company dedicated to acquiring, developing and commercializing prescription drugs used in the treatment of a variety of
gastrointestinal diseases, which are those affecting the digestive tract.

These consolidated financial statements are stated in United
States dollars and are prepared under accounting principles generally accepted in the United States, or GAAP. The accompanying condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All
significant intercompany balances and transactions have been eliminated in the consolidation.

The accompanying consolidated financial
statements include all adjustments that, in the opinion of management, are necessary for a fair presentation of financial position, results of operations and cash flows. These financial statements should be read in conjunction with the audited
consolidated financial statements included in the Companys Annual Report on Form 10-K for the fiscal year ended December 31, 2008 filed with the Securities and Exchange Commission. The results of operations for interim periods are not
necessarily indicative of results to be expected for a full year or any future period. Certain information and footnote disclosures normally included in annual financial statements prepared in accordance with GAAP have been omitted in accordance
with the SECs rules and regulations for interim reporting.

2.

Revenue Recognition

The Company recognizes revenue
in accordance with the SECs Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements as amended by Staff Accounting Bulletin No. 104 (together, SAB 101), and FASB Statement No. 48
Revenue Recognition When Right of Return Exists (SFAS 48). SAB 101 states that revenue should not be recognized until it is realized or realizable and earned. Revenue is realized or realizable and earned when all of the
following criteria are met: (a) persuasive evidence of an arrangement exists; (b) delivery has occurred or services have been rendered; (c) the sellers price to the buyer is fixed or determinable; and (d) collectibility is
reasonably assured.

SFAS 48 states that revenue from sales transactions where the buyer has the right to return the product shall be
recognized at the time of sale only if (1) the sellers price to the buyer is substantially fixed or determinable at the date of sale, (2) the buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation
is not contingent on resale of the product, (3) the buyers obligation to the seller would not be changed in the event of theft or physical destruction or damage of the product, (4) the buyer acquiring the product for resale has
economic substance apart from that provided by the seller, (5) the seller does not have significant obligations for future performance to directly bring about resale of the product by the buyer, and (6) the amount of future returns can be
reasonably estimated. The Company recognizes revenues for product sales at the time title and risk of loss are transferred to the customer, and the other criteria of SAB 101 and SFAS 48 are satisfied, which is generally at the time products are
shipped. The Companys net product revenue represents the Companys total revenues less allowances for customer credits, including estimated discounts, rebates, chargebacks, and product returns.

In its analyses, the Company uses prescription data purchased from a third-party data provider to develop estimates of historical inventory channel pull-through. The Company utilizes an internal analysis to compare historical net product
shipments to estimated historical prescriptions written. Based on that analysis, it develops an estimate of the quantity of product in the channel which may be subject to various rebate, chargeback and product return exposures. At least quarterly
for each product line, the Company prepares an internal estimate of ending inventory units in the distribution channel by adding estimated inventory in the channel at the beginning of the period, plus net product shipments for the period, less
estimated prescriptions written for the period. Based on that analysis, the Company develops an estimate of the quantity of product in the channel that might be subject to various rebate, chargeback and product return exposures. This is done for
each product line by applying a rate of historical activity for rebates, chargebacks and product returns, adjusted for relevant quantitative and qualitative factors discussed above, to the potential exposed product estimated to be in the
distribution channel. Internal forecasts that are utilized to calculate the estimated number of months in the channel are regularly adjusted based on input from members of the Companys sales, marketing and operations groups. The adjusted
forecasts take into account numerous factors including, but not limited to, new product introductions, direct communication with customers and potential product expiry issues.

The Company periodically offers promotional discounts to the Companys existing customer base. These discounts are calculated as a percentage of the
current published list price and are treated as off-invoice allowances. Accordingly, the discounts are recorded as a reduction of revenue in the period that the program is offered. In addition to promotional discounts, at the time that the Company
implements a price increase, it generally offers its existing customer base an opportunity to purchase a limited quantity of product at the previous list price. Shipments resulting from these programs generally are not in excess of ordinary levels,
therefore, the Company recognizes the related revenue upon shipment and includes the shipments in estimating various product related allowances. In the event the Company determines that these shipments represent purchases of inventory in excess of
ordinary levels for a given wholesaler, the potential impact on product returns exposure would be specifically evaluated and reflected as a reduction in revenue at the time of such shipments.

Allowances for estimated rebates and chargebacks were $11.9 million and $7.4 million as of June 30, 2009 and December 31, 2008, respectively.
These allowances reflect an estimate of the Companys liability for items such as rebates due to various governmental organizations under the Medicare/Medicaid regulations, rebates due to managed care organizations under specific contracts and
chargebacks due to various organizations purchasing our products through federal contracts and/or group purchasing agreements. The Company estimates its liability for rebates and chargebacks at each reporting period based on a methodology of
applying quantitative and qualitative assumptions discussed above. Due to the subjectivity of the Companys accrual estimates for rebates and chargebacks, the Company prepares various sensitivity analyses to ensure the Companys final
estimate is within a reasonable range as well as review prior period activity to ensure that the Companys methodology continues to be appropriate.

Allowances for product returns were $7.9 million and $8.5 million as of June 30, 2009 and December 31, 2008, respectively. These allowances reflect an estimate of the Companys liability for product
that may be returned

by the original purchaser in accordance with the Companys stated return policy. These balances do not include $5.9 million and $18.1 million at
June 30, 2009 and December 31, 2008, respectively, reflecting the Companys estimate of Colazal that may be returned to us under our return policy as a result of the approval of three generic balsalazide capsule products by the Office
of Generic Drugs on December 28, 2007. The Company estimates its liability for product returns at each reporting period based on historical return rates, estimated inventory in the channel and the other factors discussed above. Due to the
subjectivity of the Companys accrual estimates for product returns, the Company prepares various sensitivity analyses to ensure the Companys final estimate is within a reasonable range and also reviews prior period activity to ensure
that the Companys methodology is still reasonable.

Colazal, the Companys balsalazide disodium capsule, has historically
accounted for a majority of the Companys revenue prior to 2008. On December 28, 2007, the Office of Generic Drugs, or OGD, approved three generic balsalazide capsule products. As a result of these generic approvals, the Company expects
the future sales of Colazal to be significantly less than historical sales of Colazal. At June 30, 2009 and December 31, 2008, respectively, $5.9 million and $18.1 million were recorded as a liability to reflect an estimate of the
Companys liability for Colazal that may be returned by the original purchaser in accordance with the Companys stated return policy as a result of these generic approvals. The decrease in the liability from December 31, 2008 to
June 30, 2009 is a result of actual Colazal returns. This estimate is based on an estimate of Colazal inventory in the channel and related expiration dates of this inventory, estimated erosion of Colazal demand based on the generic approvals
and the resulting estimated pull-through of Colazal, and other factors. Due to the subjectivity of this estimate, the Company prepares various sensitivity analyses to ensure the Companys final estimate is within a reasonable range.

The Companys provision for revenue-reducing items such as rebates, chargebacks, and product returns as a percentage of gross product revenue in
the six-month periods ended June 30, 2009 and 2008 was 9.8% and 6.5% for rebates, chargebacks and discounts and was 6.1% and 7.9% for product returns, respectively, excluding the Colazal return reserve.

3.

Commitments

Purchase Order Commitments

At June 30, 2009, the Company had binding purchase order commitments for inventory purchases expected to be delivered over the next 5
months aggregating approximately $25.2 million.

Potential Milestone Payments

The Company has entered into collaborative agreements with licensors, licensees and others. Pursuant to the terms of these collaborative agreements, the
Company is obligated to make one or more payments upon the occurrence of certain milestones. The following is a summary of the material payments that the Company might be required to make under its collaborative agreements if certain milestones are
satisfied.

License Agreement with Cedars-Sinai Medical Center  In June 2006, the Company entered into a license agreement with
Cedars-Sinai for the right to use a patent and a patent application relating to methods of diagnosing and treating irritable bowel syndrome and other disorders caused by small intestinal bacterial overgrowth. Pursuant to the license agreement, the
Company was obligated to pay Cedars-Sinai a license fee of $1.2 million over time. As of June 30, 2009, the Company had paid this license fee in full. The Company may terminate the license agreement upon written notice of not less than 90 days.

License and Supply Agreement with the Debiopharm Group  In September 2006, the Company acquired the exclusive right to sell,
market and distribute Sanvar in the United States. Pursuant to the terms of this agreement, the Company is obligated to make an upfront and milestone payments to Debiopharm that could total up to $8.0 million contingent upon achievement of certain
regulatory milestones, and an additional $6.0 million in milestone payments contingent on reaching certain sales thresholds over the term of the agreement. As of June 30, 2009, the Company had paid $1.0 million of milestone payments. The
remaining milestone payments are contingent upon achievement of regulatory approval and certain sales thresholds. Under the terms of the agreement, on August 4, 2009, the Company provided a 30-day notice to Debiopharm of termination of the
agreement because the FDA did not approve Sanvar.

License Agreement with Dr. Falk Pharma GmbH for granulated mesalamine 
In July 2002, the Company and Dr. Falk entered into a license agreement which they amended in November 2003 and February 2005. Pursuant

to the license agreement, as amended, the Company acquired the rights to develop and market a granulated formulation of mesalamine. The agreement provides
that the Company is obligated to make milestone payments up to an aggregate amount of $11.0 million to Dr. Falk. As of June 30, 2009, the Company had paid $9.0 million of milestone payments. The remaining milestone payment is contingent
upon achievement of additional regulatory approval.

License Agreement with Dr. Falk Pharma GmbH for budesonide  In March 2008,
the Company entered into a License Agreement with Dr. Falk. The agreement provides the Company with an exclusive license to develop and commercialize in the United States Dr. Falks budesonide products. The products covered in the
License Agreement include U.S. patent-protected budesonide rectal foam and budesonide gastro-resistant capsule, patents for which expire in 2015 and 2016, respectively. Pursuant to the license agreement the Company is obligated to make an upfront
payment and regulatory milestone payments that could total up to $23.0 million, with the majority contingent upon achievement of U.S. regulatory approval. As of June 30, 2009, the Company had paid $1.0 million of these milestone payments.

License Agreement with Merck & Co, Inc.  In February 2007, the Company entered into a Master Purchase
and Sale and License Agreement with Merck, paying Merck $55.0 million to purchase the U.S. prescription pharmaceutical product rights to Pepcid® Oral Suspension and Diuril® Oral
Suspension. Pursuant to the license agreement, the Company is obligated to make additional milestone payments to Merck up to an aggregate of $6.0 million contingent upon reaching certain sales thresholds during any of the five calendar years
beginning in 2007 and ending in 2011.

License Agreement with Napo Pharmaceuticals, Inc.  In December 2008 the Company entered into a
Collaboration Agreement with Napo. Pursuant to the agreement, the Company has an exclusive, royalty-bearing license to crofelemer for the treatment of HIV-associated diarrhea and additional indications of pediatric diarrhea and acute infectious
diarrhea in a certain territory. The Company also has a non-exclusive, worldwide, royalty-bearing license to use Napo-controlled trademarks associated with crofelemer. The Company made an initial payment of $5.0 million to Napo and will make up to
$50.0 million in milestone payments to Napo contingent on regulatory approvals and up to $250.0 million in milestone payments contingent on reaching certain sales thresholds. The Company is responsible for development costs of crofelemer, but costs
exceeding $12.0 million for development of crofelemer used for the HIV-associated diarrhea indication will be credited towards regulatory milestones and thereafter against sales milestones.

License and Supply Agreement with Norgine B.V.  In December 2005, the Company entered into a license and supply agreement with Norgine for the
rights to sell a bowel cleansing product the Company now markets in the United States under the trade name MoviPrep. Pursuant to the terms of this agreement, the Company is obligated to make upfront and milestone payments to Norgine that could total
up to $37.0 million over the term of the agreement. As of June 30, 2009, the Company had paid $22.0 million of milestone payments. The remaining milestone payments are contingent upon reaching sales thresholds.

License Agreement with Wilmington Pharmaceuticals, LLC  In September 2007, the Company entered into an Exclusive Sublicense Agreement with
Wilmington Pharmaceuticals. The agreement provides that the Company is obligated to make upfront and milestone payments up to an aggregate amount of $8.0 million to Wilmington. As of June 30, 2009, the Company had paid $1.0 million of these
milestone payments. The remaining milestone payment is contingent upon regulatory approval. The Company also loaned Wilmington $2.0 million which is due on the earlier of December 31, 2009 or regulatory approval.

4.

Fair Value of Financial Instruments

The carrying
amounts of the Companys financial instruments, which include cash and cash equivalents, accounts receivable, accounts payable, accrued liabilities and capital lease obligations, approximated their fair values as of June 30, 2009 and
December 31, 2008 due to the short-term nature of these financial instruments. The carrying amount of the Companys credit facility approximated its fair value at June 30, 2009 and December 31, 2008 due to the fact that interest
rate was determined based on prevalent market rates.

The Company considers
all highly liquid investments with maturities from date of purchase of three months or less to be cash equivalents. The Company maintains its cash and cash equivalents in several different financial instruments with various banks and brokerage
houses. This diversification of risk is consistent with Company policy to maintain liquidity and ensure the safety of principal. At June 30, 2009, cash and cash equivalents consisted primarily of demand deposits, overnight investments in
Eurodollars, certificates of deposit and money market funds at reputable financial institutions, and did not include any auction rate securities.

6.

Inventory

Raw materials, work-in-process and
finished goods inventories are stated at the lower of cost (which approximates actual cost on a first-in, first-out cost method) or market value. In evaluating whether inventory is stated at the lower of cost or market, management considers such
factors as the amount of inventory on hand and in the distribution channel, estimated time required to sell such inventory, remaining shelf life, and current and expected market conditions, including levels of competition, including generic
competition.

The Company expenses pre-approval inventory unless the Company believes it is probable that the inventory will be saleable.
The Company capitalizes inventory costs associated with marketed products and certain products prior to regulatory approval and product launch, based on managements judgment of probable future commercial use and net realizable value.
Capitalization of this inventory does not begin until the product candidate is considered to have a high probability of regulatory approval, which is generally after the Company has analyzed Phase III data or filed an NDA. If the Company is aware of
any specific risks or contingencies that are likely to impact the regulatory approval process or if there are any specific issues identified during the research process relating to safety, efficacy, manufacturing, marketing or labeling of the
product candidate, the Company does not capitalize the related inventory. Once the Company capitalizes inventory for a product candidate that is not yet approved, the Company monitors, on a quarterly basis, the status of this candidate within the
regulatory approval process. The Company could be required to expense previously capitalized costs related to pre-approval inventory upon a change in its judgment of future commercial use and net realizable value, due to a denial or delay of
approval by regulatory bodies, a delay in the timeline for commercialization or other potential factors. On a quarterly basis, the Company evaluates all inventory, including inventory capitalized for which regulatory approval has not yet been
obtained, to determine if any lower of cost or market adjustment is required. As it relates to pre-approval inventory, the Company considers several factors including expected timing of FDA approval, projected sales volume and estimated selling
price.

Inventory at June 30, 2009 consisted of $9.1 million of raw materials, $5.9 million of work-in-process, and $4.6 million of
finished goods. Inventory at December 31, 2008 consisted of $8.5 million of raw materials, $6.5 million of work-in-process, and $2.3 million of finished goods. As of June 30, 2009, inventory reserves totaling $3.1 million, compared to $3.8
million as of December 31, 2008, have been recorded to reduce inventories to their net realizable value.

7.

Intangible Assets and Goodwill

The Companys
intangible assets consist of license agreements, product rights and other identifiable intangible assets, which result from product and business acquisitions. Goodwill represents the excess purchase price over the fair value of assets acquired and
liabilities assumed in a business combination.

When the Company makes product acquisitions that include license agreements, product rights
and other identifiable intangible assets, it records the purchase price of such intangibles, along with the value of the product related liabilities that it assumes, as intangible assets. The Company allocates the aggregate purchase price to the
fair value of the various tangible and intangible assets in order to determine the appropriate carrying value of the acquired assets and then amortizes the cost of the intangible assets as an expense in its consolidated statement of operations over
the estimated economic useful life of the related assets. In accordance with Statement of Financial Accounting Standards No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, the Company

assesses the impairment of identifiable intangible assets whenever events or changes in circumstances indicate that the carrying value might not be
recoverable. The Company believes that the following factors could trigger an impairment review: significant underperformance relative to expected historical or projected future operating results; significant changes in the manner of the
Companys use of the acquired assets or the strategy for the Companys overall business; and significant negative industry or economic trends.

In assessing the recoverability of its intangible assets, the Company must make assumptions regarding estimated future cash flows and other factors. If the estimated undiscounted future cash flows do not exceed the
carrying value of the intangible assets, the Company must determine the fair value of the intangible assets. If the fair value of the intangible assets is less than the carrying value, the Company will recognize an impairment loss in an amount equal
to the difference. The Company reviews goodwill for impairment on an annual basis, and goodwill and other intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset might not be
recoverable.

The Company assesses impairment of goodwill on an annual basis in accordance with Statement of Financial Accounting Standards
No. 142, Goodwill and Other Intangible Assets.

In November 2003, the Company acquired from aaiPharma LLC for $2.0 million
the exclusive right to sell 25, 75 and 100 milligram dosage strengths of azathioprine tablets in North America under the name Azasan. The purchase price was fully allocated to product rights and related intangibles and is being amortized over a
period of ten years. Although Azasan does not have any patent protection, the Company believes ten years is an appropriate amortization period based on established product sales history and managements experience. At June 30, 2009
accumulated amortization for the Azasan intangible was $1.1 million.

In June 2004, the Company acquired the exclusive U.S. rights to
Anusol-HC 2.5% (hydrocortisone Cream USP), Anusol-HC 25 mg Suppository (Hydrocortisone Acetate), Proctocort Cream (Hydrocortisone Cream USP) 1% and Proctocort Suppositories (Hydrocortisone Acetate Rectal Suppositories, 30 mg) from King
Pharmaceuticals, Inc. for $13.0 million. The purchase price was fully allocated to product rights and related intangibles and is being amortized over a period of ten years. Although Anusol-HC and Proctocort do not have any patent protection, the
Company believes ten years is an appropriate amortization period based on established product sales history and managements experience. At June 30, 2009 accumulated amortization for the King product intangibles was $6.5 million.

In September 2005, the Company acquired InKine Pharmaceutical Company, Inc. for $210.0 million. The Company allocated $74.0 million of the
purchase price to in-process research and development, $9.3 million to net assets acquired and $37.0 million to specifically identifiable product rights and related intangibles with an ongoing economic benefit to the Company. The Company allocated
the remaining $89.7 million to goodwill, which is not being amortized. The InKine product rights and related intangibles are being amortized over an average period of 14 years, which the Company believes is an appropriate amortization period due to
the products patent protection and the estimated economic lives of the product rights and related intangibles. At June 30, 2009 accumulated amortization for the InKine intangibles was $11.3 million.

In December 2005, the Company entered into a License and Supply Agreement with Norgine B.V., granting Salix the exclusive right to sell a
patented-protected, liquid PEG bowel cleansing product in the United States. In August 2006, the Company received Food and Drug Administration marketing approval for this product under the branded name of MoviPrep. In January 2007 the United States
Patent Office issued a patent providing coverage to September 1, 2024. In August 2006, pursuant to the terms of the agreement, Salix made a $15.0 million payment to Norgine. In December 2008, pursuant to the terms of the agreement, the Company
made a $5.0 million payment to Norgine. The Company is amortizing these milestone payments over a period of 17.3 years, which the Company believes is an appropriate amortization period due to the products patent protection and the estimated
economic life of the related intangible. At June 30, 2009 accumulated amortization for the MoviPrep intangible was $2.6 million.

In
February 2007, the Company entered into a Master Purchase and Sale and License Agreement with Merck & Co. Inc., to purchase the U.S prescription pharmaceutical product rights to Pepcid Oral Suspension and Diuril Oral Suspension from Merck.
The Company paid Merck $55.0 million at the closing of this transaction. The purchase price was fully allocated to product rights and related intangibles, and is being amortized over a period of

15 years. Although Pepcid and Diuril do not have patent protection, the Company believes 15 years is an appropriate amortization period based on established
product history and management experience. At June 30, 2009 accumulated amortization for the Merck products was $8.7 million.

In July
2002, the Company acquired the rights to develop and market a granulated formulation of mesalamine from Dr. Falk Pharma GmbH. On October 31, 2008, the FDA granted marketing approval for the product under the name Apriso, for the
maintenance of remission of ulcerative colitis in adults. In November 2008, the Company made a $6.0 million milestone payment to Dr. Falk. The Company is amortizing this milestone payment over a period of 9.5 years, which the Company believes
is an appropriate amortization period due to the products patent protection and the estimated economic life of the related intangible. At June 30, 2009, accumulated amortization for the Apriso intangible was $0.4 million.

8.

Credit Facility

In February 2007, the Company
entered into a $100.0 million revolving credit facility that matures in February 2012. On August 4, 2008 the credit facility was amended to waive defaults that might have resulted from the approval of three generic balsalazide capsule
products by the Office of Generic Drugs on December 28, 2007, and the credit facility was reduced to $20.0 million. On August 22, 2008 the credit facility was further amended to allow the Company to issue the convertible Notes described in
Note 9 below. At June 30, 2009, $15.0 million was outstanding under the credit facility. Virtually all assets of the Company and its subsidiaries collateralize the Companys obligations under the credit facility. Borrowings under the
credit facility may be used for working capital, capital expenditures, acquisitions and other general corporate purposes.

The credit facility bears interest at a rate per annum equal to, at the Companys option, either (a) a base rate equal to the higher of (i) the Federal Funds Rate plus 1/2 of 1% and (ii) the Bank of America prime rate, or (b) a Eurodollar
rate (based on LIBOR), plus 0.00% for base rate borrowings and 1.00% for Eurodollar rate borrowings. The Company must maintain an amount equal to the amount outstanding under the credit facility on deposit with the Administrative Agent of the credit
facility and maintain a minimum of $23.0 million in cash on its balance sheet. At June 30, 2009, restricted cash of $15.0 million represents the collateral on deposit with the Administrative Agent related to the credit facility. At
June 30, 2009 the Company was in compliance with applicable covenants under the credit facility.

9.

Convertible Senior Notes

On August 22, 2008
the Company closed an offering of $60 million in Convertible Senior Notes (Notes) due 2028. Net proceeds from the offering were $57.3 million. The Notes are governed by an indenture, dated as of August 22, 2008, between the Company
and U.S. Bank National Association, as trustee.

The Notes bear interest at a rate of 5.5% per year, payable semiannually in arrears
on February 15 and August 15 of each year, beginning on February 15, 2009. The Notes will mature on August 15, 2028, unless previously converted or repurchased in accordance with their terms prior to such date.

The Notes are senior unsecured obligations, and rank (i) equally to any of the Companys existing and future unsecured senior debt,
(ii) senior to any of the Companys future indebtedness that is expressly subordinated to these Notes, and (iii) effectively junior to any secured indebtedness to the extent of the value of the assets securing such indebtedness.

The Company may redeem the Notes, in whole or in part, at any time after August 15, 2013 for cash equal to the principal amount of
the Notes to be redeemed, plus any accrued and unpaid interest.

On August 15, 2013, August 15, 2018 and August 15,
2023 or upon the occurrence of a fundamental change, as defined in the indenture, the holders may require the Company to repurchase all or a portion of the Notes for cash at 100% of the principal amount of the Notes being purchased, plus
any accrued and unpaid interest.

The Notes are convertible into approximately 6,486,000 shares of the Companys common stock
under certain circumstances prior to maturity at a conversion rate of 108.0847 shares per $1,000 principal amount of Notes, which represents a conversion price of approximately $9.25 per share, subject to adjustment under certain conditions. Holders
of the Notes may convert their Notes at their option on any day prior to the close of business on the business day immediately preceding the maturity date of August 15, 2028 only if one or more of the following conditions is satisfied:
(1) during any fiscal quarter commencing after September 30, 2008, if the last reported sale price of the Companys common stock for at least 20 trading days in the period of 30 consecutive trading days ending on the last trading day
of the immediately preceding fiscal quarter is equal to or more than 130% of the conversion price of the Notes on the last day of such preceding fiscal quarter; (2) during the five business day period following any five consecutive trading day
period in which the trading price for the Notes, per $1,000 principal amount of the Notes, for each such trading day was less than 98% of the product of the last reported sale price of the Companys common stock and the conversion rate of the
Notes on such date; (3) if the Company enters into specified corporate transactions; or (4) upon a redemption notice. The Notes will be convertible, regardless of whether any of the foregoing conditions have been satisfied, on or after
March 15, 2028 at any time prior to the close of business on the business day immediately preceding the stated maturity date of August 15, 2028. Upon conversion, the Company may pay cash, shares of the Companys common stock or a
combination of cash and stock, as determined by the Company in its discretion.

As long as the Notes are outstanding, the Company and its
subsidiaries are prohibited from incurring any debt other than permitted debt, as defined in the indenture, except that the Company and its subsidiaries may incur debt in certain circumstances, including meeting a consolidated leverage
ratio test and a consolidated fixed charge coverage ratio test. The Company may refinance its existing credit facility provided the refinanced credit facility contains substantially the same restrictive covenants with respect to financial ratios as
the existing credit facility did as of August 22, 2008.

In connection with the issuance of the Notes, the Company incurred $2.7
million of issuance costs, which primarily consisted of investment banker fees, legal and other professional fees. These costs are being amortized and are recorded as additional interest expense through August 2013, the first scheduled date on which
holders have the option to require the Company to repurchase the Notes.

In May 2008, the FASB issued FASB Staff Position (FSP)
No. APB 14-1, Accounting for Convertible Debt Instruments That May Be Settled in Cash upon Conversion (including Partial Cash Settlement), which is effective for financial statements issued for fiscal years beginning after
December 15, 2008. Early adoption is not permitted. This FSP applies to convertible debt instruments that may be settled in cash and requires separate accounting for the liability and equity components of the convertible debt. The Notes may be
settled in cash. As a result, the Company adopted this FSP on January 1, 2009, and as required, applied the FSP retrospectively to all periods presented.

This FSP requires the Company to separately account for the liability and equity components of the convertible debt instrument by allocating the proceeds from issuance of the Notes between the liability component and
the embedded conversion option, or equity component. This allocation was done by first estimating an interest rate at the time of issuance for similar notes that do not include the embedded conversion option. This interest rate of 12.5% was used to
compute the initial fair value of the liability component of $44.1 million. The excess of the initial proceeds received from the convertible Notes over the initial amount allocated to the liability component, of $15.9 million, is allocated to the
embedded conversion option, or equity component. This excess is reported as a debt discount and subsequently amortized as interest cost, using the interest method, through August 2013, the first scheduled date on which the holders have the option to
require the Company to repurchase the Notes.

The balance sheet at December 31, 2008 has been adjusted to reflect the retrospective
application of this FSP. The carrying value of the liability component was decreased by $15.2 million to reflect the initial carrying value, less 2008 amortization of the debt discount of $0.7 million. Additional paid-in capital was increased by
$15.2 million to reflect the initial value of the equity component of $15.9 million, less the issuance costs related to the equity component of $0.7 million. Accumulated deficit was increased by $0.6 million to reflect the amortization of the debt
discount for 2008, less issuance cost amortization for 2008 related to the equity component. Other assets were decreased by $0.7 related to the issuance costs related to the equity component.

The carrying value of the equity component at June 30, 2009 and December 31, 2008 was $15.2
million. The effective interest rate on the liability component for the three-month and six-month periods ended June 30, 2008 was 12.6%. Total interest cost of $1.5 million and $3.0 million was recognized during the three-month and six-month
periods ended June 30, 2009, respectively including $0.6 million and $1.2 million of amortization of debt discount, respectively.

The
following table summarizes information on our convertible debt as of:

June 30,2009

December 31,2008

Principal amount of the liability component

$

60,000

$

60,000

Unamortized discount

(14,010

)

(15,241

)

Net carrying amount

$

45,990

$

44,759

10.

Research and Development

The Company expenses
research and development costs, both internal and externally contracted, as incurred. For nonrefundable advance payments for goods or services that will be used or rendered for future research and development activities, the Company initially
capitalizes the advance payment. Such amounts are then recognized as an expense as the related goods are delivered or the related services are performed.

11.

Comprehensive Income

The Company adopted SFAS
No. 130, Reporting Comprehensive Income effective January 1, 1998. SFAS 130 requires that the Company display an amount representing comprehensive income (loss) for the year in a financial statement, which is displayed with the
same prominence as other financial statements. The Company elected to present this information in the Consolidated Statements of Stockholders Equity. Other comprehensive income (loss) consists of foreign currency translation gains and losses,
as well as any unrealized gains and losses on investments. For the periods presented, comprehensive income (loss) equaled reported net income (loss).

12.

Share-Based Compensation

At June 30, 2009,
the Company had one active share-based compensation plan, the 2005 Stock Plan, allowing for the issuance of stock options and restricted stock. The Company accounts for share-based compensation under SFAS No 123R, Share-Based Payment,
which requires that companies estimate the fair value of share-based payment awards on the date of the grant. The cost is to be recognized over the period during which an employee is required to provide service in exchange for the award. The
valuation provisions of SFAS 123R apply to new grants and grants modified after the adoption date that were outstanding as of the effective date.

Starting in 2006, the Company began issuing restricted shares to employees, executives and directors of the Company. For employees and executives of the Company, restrictions lapse 25% annually over four years or 33.3% over three
years. For board members of the company, restrictions lapse 100% after one year. The fair value of the restricted stock was estimated using an assumed forfeiture rate of 8.8% and is being expensed on a straight-line basis over the period
during which the restrictions lapse. For the six-month periods ended June 30, 2009 and 2008, the Company recognized $2.9 million and $2.1 million in share-based compensation expense related to the restricted shares, respectively. For the
three-month periods ended June 30, 2009 and 2008, the Company recognized $1.5 million and $1.1 million in share-based compensation expense related to the restricted shares, respectively. As of June 30, 2009, the total amount of
unrecognized compensation cost related to nonvested restricted stock awards, to be recognized as expense subsequent to June 30, 2009, was approximately $8.9 million, and the related weighted-average period over which it is expected to be
recognized is approximately 2.06 years.

For the six-month period ended June 30, 2009, the Company issued 189,504 shares of stock with
a market value of $1.9 million upon the exercise of stock options. The Company recognized no share-based compensation expense related to stock options for the six-month period ended June 30, 2009, nor any income tax benefit. The total intrinsic
value of options exercised for the six-month period ended June 30, 2009 was $1.0 million. As of June 30, 2009, there was no unrecognized compensation cost for stock options because all stock options were fully vested. For the six-month
period ended June 30, 2009, the Company received $0.9 million in cash from stock option exercises.

13.

Income Taxes

The Company provides for income taxes
under the liability method in accordance with SFAS No. 109, Accounting for Income Taxes. This approach requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of differences between
the tax basis of assets or liabilities and their carrying amounts in the consolidated financial statements. The Company provides a valuation allowance for deferred tax assets if it is more likely than not that these items will either expire before
the Company is able to realize their benefit or if future deductibility is uncertain.

In June 2006, the FASB issued FASB Interpretation
No. 48 Accounting for Uncertainty in Income Taxes (FIN 48), which is an interpretation of SFAS 109 Accounting for Income Taxes. This interpretation prescribes a recognition threshold and measurement attribute
for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return and also provides guidance on derecognizing, classification, interest and penalties, accounting in interim periods, disclosure
and transition.

On January 1, 2007, the Company adopted the provisions of FIN 48. As a result of applying the provisions of FIN 48,
the Company recognized an increase of $2.4 million in the liability for unrecognized tax benefits and a reduction in the valuation allowance as of January 1, 2007, for the same amount. The unrecognized tax benefits as of June 30, 2009
relate to federal tax credit carryforwards. The Company continues to fully recognize its tax benefits which are offset by a valuation allowance to the extent that it is more likely than not that the deferred tax assets will not be realized. The
Company does not expect any significant changes in its unrecognized tax benefits for the next twelve months.

The Company files a
consolidated U.S. federal income tax return and consolidated and separate company income tax returns in many U.S. state jurisdictions. Generally, the Company is no longer subject to federal and state income tax examinations by U.S. tax authorities
for years prior to 1993.

The Company recognizes any interest accrued related to unrecognized tax benefits in interest expense and
penalties in operating expenses. During the six-month periods ended June 30, 2009 and 2008, there was no such interest or penalties.

The provision for income taxes reflects the Companys estimate of the effective tax rate expected to be

applicable for the full fiscal year. The Companys effective tax rate for the three-month and six-month periods ended June 30, 2009 were 0.3% and
0.3%, respectively. The Companys effective tax rate for the three-month and six-month periods ended June 30, 2008 were (7.5)% and (3.7)%, respectively. The Company re-evaluates this estimate each quarter based on the Companys
estimated tax expense for the year.

14.

Net Income (Loss) per Share

The Company computes
net income (loss) per share in accordance with SFAS No. 128, Earnings Per Share (SFAS 128). Under the provisions of SFAS 128, basic net income (loss) per share is computed by dividing net income (loss) by the weighted
average number of common shares outstanding. Diluted net income (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares and dilutive common share equivalents then outstanding. Common share
equivalents consist of the incremental common shares issuable upon the exercise of stock options and the impact of vested restricted stock grants. Under the provisions of SFAS 128, the Company will account for the effect of the convertible Notes on
diluted net income (loss) per share using the treasury stock method. As a result, the convertible Notes will have no effect on diluted net income (loss) per share until the Companys stock price exceeds the conversion price of $9.25 per share.
For the three-month and six-month periods ended June 30, 2009, the effect of approximately 6,486,000 shares issuable upon conversion of the Notes were excluded from the diluted net income per share calculation, because their inclusion would
have an anti-dilutive effect due to the net loss during those periods.

The following table reconciles the numerator and denominator used
to calculate diluted net income (loss) per share (in thousands):

Three months endedJune 30,

Six months endedJune 30,

2009

2008

2009

2008

Numerator:

Net income (loss)

$

(15,317

)

$

(7,089

)

$

(29,283

)

$

(31,086

)

Denominator:

Weighted average common shares, basic

48,240

47,763

48,175

47,743

Dilutive effect of stock options









Dilutive effect of restricted stock









Weighted average common shares, diluted

48,240

47,763

48,175

47,743

For the three-month ended June 30, 2009 and 2008, weighted average common shares, diluted are
equal to weighted average common shares, basic, because inclusion of the effect of 1,385,672 and 636,986 shares of restricted stock and stock options, respectively, would have an anti-dilutive effect due to the net loss during those periods. For the
six-month periods ended June 30, 2009 and 2008, weighted average common shares, diluted are equal to weighted average common shares, basic, because inclusion of the effect of 1,208,918 and 608,654 shares of restricted stock and stock options,
respectively, would have an anti-dilutive effect due to the net loss during that period. For the three-month periods ended June 30, 2009 and 2008, there were 2,379,634 and 4,862,181, respectively, potential common shares outstanding that were
excluded from the diluted net income per share calculation because their effect would have been anti-dilutive. For the six-month periods ended June 30, 2009 and 2008, there were 2,943,954 and 4,874,555, respectively, potential common shares
outstanding that were excluded from the diluted net income per share calculation because their effect would have been anti-dilutive.

The Company operates in a single
industry acquiring, developing and commercializing prescription drugs used in the treatment of a variety of gastrointestinal diseases, which are those affecting the digestive tract. Accordingly, the Companys business is classified as a single
reportable segment.

In April
2009, the FASB issued FSP No. FAS 157-4, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly. FSP No. FAS 157-4
amends SFAS No. 157 and provides additional guidance for estimating fair value in accordance with SFAS No. 157 when the volume and level of activity for the asset and liability have significantly decreased, as well as guidance on
identifying circumstances that indicate a transaction is not orderly. FSP No. FAS 157-4 is effective for interim and annual periods ending after June 15, 2009. The adoption of FSP No. FAS 157-4 is not expected to have a material
impact on the Companys consolidated results of operations, cash flows or financial position.

In April 2009, FASB issued FSP
No. FAS 115-2 and FAS 124-2, Recognition and Presentation of Other-Than-Temporary Impairments. FSP No. FAS 115-2 and FAS 124-2 amends SFAS No. 115, Accounting for Certain Investments in Debt and Equity
Securities and FSP No. FAS 115-1 and FAS 124-1, The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments. FSP No. FAS 115-2 and FAS 124-2 provide additional guidance to make
other-than-temporary impairments more operational and to improve the financial statement presentation of such impairments. FSP No. FAS 115-2 and FAS 124-2 are effective for interim and annual periods ending after June 15, 2009. The
adoption of FSP No. FAS 115-2 and FAS 124-2 is not expected to have a material impact on the Companys consolidated results of operations, cash flows or financial position.

In April 2009, FASB issued FSP No. FAS 107-1 and APB 28-1, Interim Disclosures about Fair Value of Financial Instruments. FSP
No. FAS 107-1 and APB 28-1 amends SFAS No. 107, Disclosures about Fair Value of Financial Instruments and APB Opinion No. 28, Interim Financial Reporting, by requiring disclosures about fair value of financial
instruments in interim financial statements as well as in annual financial statements. FSP No. FAS 107-1 and APB 28-1 are effective for interim periods ending after June 15, 2009. The adoption of FSP No. FAS 107-1 and APB 28-1 is not
expected to have a material impact on the Companys consolidated results of operations, cash flows or financial position.

In May
2009, the FASB issued SFAS No. 165, Subsequent Events, which requires the Company to disclose the date through which it has evaluated subsequent events and the basis for that date, whether that date represents the date the financial
statements were issued or were available to be issued. SFAS 165 is effective for interim and

annual reporting periods ending after June 15, 2009. The Company adopted SFAS No. 165 in our second quarter with no material impact on our
consolidated financial statements.

In June 2009, the FASB issued SFAS No. 168, The FASB Accounting Standards Codification and
the Hierarchy of Generally Accepted Accounting Principles - A Replacement of FASB Statement No. 162. The objective is to replace SFAS No. 162 and to establish the FASB Accounting Standards Codification as the source of authoritative
accounting principles recognized by the FASB to be applied by nongovernmental entities in the preparation of financial statements in conformity with GAAP. Rules and interpretive releases of the SEC under authority of federal securities laws are also
sources of authoritative GAAP for SEC registrants. SFAS 168 does not change GAAP. SFAS 168 is effective for financial statements issued for interim and annual periods ending after September 15, 2009. The adoption of SFAS No. 168 will not
have a material impact on the Companys consolidated financial statements.

17.

Legal Proceedings

From time to time, the Company
is party to various legal proceedings or claims, either asserted or unasserted, which arise in the ordinary course of business. Management has reviewed pending legal matters and believes that the resolution of such matters will not have a
significant adverse effect on the Companys financial condition or results of operations.

The Company is involved in a lawsuit
against a company seeking FDA approval to market a generic version of the Companys MoviPrep product. Norgine, B.V. and Norgine Europe, B.V. own U.S. Patent No. 7,169,381 (the 381 patent). The 381 patent is listed with the FDA
as protecting our MoviPrep product. Norgine licensed MoviPrep and the 381 patent to the Company for commercialization in the United States. Novel Laboratories, Inc., filed an Abbreviated New Drug Application, or ANDA, with the FDA seeking
approval to market a generic version of MoviPrep in the United States prior to the September 2024 expiration of the 381 patent. On May 14, 2008, the Company and Norgine filed a lawsuit in the United States District Court for the District
of New Jersey against Novel for infringement of the 381 patent. Novel filed an Answer and Counterclaims on June 20, 2008. On June 25, 2009 the Company and Norgine amended the complaint to add a claim for correction of inventorship
for the 381 patent. Novel has denied infringement and asserted various affirmative defenses, including defenses of patent invalidity and unenforceability. No trial date has been set. The Company intends to vigorously defend the patent rights
for MoviPrep.

The Company is also involved in a lawsuit against Novel because Novel is seeking FDA approval to market a generic version of
the Companys OsmoPrep product. CDC, LLC, owns U.S. Patent No. 5,616,346 (the 346 patent). The 346 patent is listed with the FDA as protecting the Companys OsmoPrep product. CDC, by its predecessor, licensed OsmoPrep and
the 346 patent to the Company for commercialization in the United States. Novel filed an ANDA with the FDA seeking approval to market a generic version of OsmoPrep in the United States prior to the May 2013 expiration of the 346 patent.
On September 8, 2008, the Company filed a lawsuit in the United States District Court for the District of New Jersey against Novel for the infringement of the 346 patent. The lawsuit also joins CDC as a party. Novel filed an Answer and
Counterclaims on December 16, 2008. Novel denied infringement and asserted a defense of patent invalidity. No trial date has been set. The Company intends to vigorously defend the patent rights for OsmoPrep.

On or about July 14, 2008, Strides Arcolab Limited filed a Citizens Petition with the FDA seeking permission to submit an ANDA for change of dosage
form from tablet to capsule for a 200mg generic version of Xifaxan. The Company intends to vigorously enforce the regulatory and intellectual property rights regarding Xifaxan. The Company is unable to predict the outcome of any ensuing regulatory
action or litigation at the present time.

Regulatory data exclusivity for Xifaxan 200mg tablets ended on or about May 24, 2009.
Accordingly, the Office of Generic Drugs would have been able to accept an ANDA for Xifaxan tablets on or any time subsequent to May 24, 2008, if the applicant certified that its generic rifaximin does not infringe Salixs patent. If this
occurred, a Paragraph IV notification would have to be provided to the Company by the applicant. Although the Company does not possess any specific knowledge of any such filing at the current time, the expiration of data exclusivity could result in
a challenge to the related intellectual property rights of Xifaxan 200mg tablets at any time in the future. The Company intends to vigorously enforce the patent rights for Xifaxan.

Managements Discussion and Analysis of Financial Condition and Results of Operations

This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934. These forward-looking statements are subject to risks and uncertainties, including those set forth under Part I. Item 1A. Risk Factors in our Annual Report on Form 10-K for the year ended
December 31, 2008, and Cautionary Statement included in this Part I. Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations and elsewhere in this report, that could cause
actual results to differ materially from historical results or anticipated results. The following discussion should be read in conjunction with our Condensed Consolidated Financial Statements and notes thereto included elsewhere in this report.

Overview

We are a specialty
pharmaceutical company dedicated to acquiring, developing and commercializing prescription drugs used in the treatment of a variety of gastrointestinal disorders, which are those affecting the digestive tract. Our strategy is to:



identify and acquire rights to products that we believe have potential for near-term regulatory approval or are already approved;



apply our regulatory, product development, and sales and marketing expertise to commercialize these products; and



use our approximately 150-member specialty sales and marketing team focused on high-prescribing U.S. gastroenterologists, who are doctors who specialize in
gastrointestinal disorders, to sell our products.

Our current products demonstrate our ability to execute this strategy.
As of June 30, 2009, our products were:

We generate revenue primarily by selling our products, namely prescription drugs, to pharmaceutical wholesalers.
These direct customers resell and distribute our products to and through pharmacies to patients who have had our products prescribed by doctors. We currently market our products, and intend to market future products, if approved by the U.S. Food and
Drug Administration, or FDA, to U.S. gastroenterologists and other physicians through our own direct sales force. In December 2000, we established our own field sales force to market Colazal in the United States. Currently, this sales force has
approximately 100 sales representatives in the field and markets our approved products. Although the creation of an independent sales organization involved substantial costs, we believe that the financial returns from our direct product sales have
been and will continue to be more favorable to us than those from the indirect sale of products through marketing partners. We enter into distribution

or licensing relationships outside the United States and in certain markets in the U.S. where a larger sales organization is appropriate. Currently, our
sales and marketing staff, including our sales representatives, consists of approximately 150 people.

Because demand for our products
originates with doctors, our sales force calls on high-prescribing specialists, primarily gastroenterologists, and we monitor new and total prescriptions for our products as key performance indicators for our business. Prescriptions result in our
products being used by patients, requiring our direct customers to purchase more products to replenish their inventory. However, our revenue might fluctuate from quarter to quarter due to other factors, such as increased buying by wholesalers in
anticipation of a price increase or because of the introduction of new products. Revenue could be less than anticipated in subsequent quarters as wholesalers increased inventory is used up.

Our primary product candidates currently under development and their status are as follows:

Compound

Indication

Status

Rifaximin

Hepatic encephalopathy

NDA Submitted June 24, 2009

Rifaximin

Irritable bowel syndrome

Phase III

Rifaximin

Travelers diarrhea prevention

Phase III

Rifaximin

C. difficile  associated diarrhea

Phase III

Metozolv (metoclopramide)

Gastroparesis and refractory gastroesophageal reflux

Complete response submitted March 10, 2009

Crofelemer

HIV-associated diarrhea

Phase III

Balsalazide disodium tablet

Ulcerative colitis

Complete response letter received December 22, 2008

Critical Accounting Policies

In our Annual Report on Form 10-K for the year ended December 31, 2008, we identified our most critical accounting policies and estimates upon which our financial status depends as those relating to revenue
recognition, allowance for product returns, allowance for rebates and coupons, inventory, intangible assets and goodwill, allowance for uncollectible accounts, cash and cash equivalents, and research and development expenses. We reviewed our
policies and determined that those policies remained our most critical accounting policies for the six-month period ended June 30, 2009. We did not make any changes in those policies during the quarter.

We recognize revenue in accordance with the SECs Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements as
amended by Staff Accounting Bulletin No. 104 (together, SAB 101), and FASB Statement No. 48, Revenue Recognition When Right of Return Exists (SFAS 48). SAB 101 states that revenue should not be
recognized until it is realized or realizable and earned. Revenue is realized or realizable and earned when all of the following criteria are met: (a) persuasive evidence of an arrangement exists; (b) delivery has occurred or services have
been rendered; (c) the sellers price to the buyer is fixed and determinable; and (d) collectibility is reasonably assured.

SFAS 48 states that revenue from sales transactions where the buyer has the right to return the product shall be recognized at the time of sale only if (1) the sellers price to the buyer is substantially fixed or determinable at
the date of sale, (2) the buyer has paid the seller, or the buyer is obligated to pay the seller and the obligation is not contingent on resale of the product, (3) the buyers obligation to the seller would not be changed in the event
of theft or physical destruction or damage of the product, (4) the buyer acquiring the product for resale has economic substance apart from that provided by the seller, (5) the seller does not have significant obligations for future
performance to directly bring about resale of the product by the buyer, and (6) the amount of future returns can be

reasonably estimated. We recognize revenues for product sales at the time title and risk of loss are transferred to the customer, and the other criteria of
SAB 101 and SFAS 48 are satisfied, which is generally at the time products are shipped. Our net product revenue represents our total revenues less allowances for customer credits, including estimated discounts, rebates, chargebacks, and product
returns.

We establish allowances for estimated rebates, chargebacks and product returns based on numerous quantitative and qualitative
factors, including:



the number of and specific contractual terms of agreements with customers;

In our analyses, we use prescription data purchased from a third-party data provider to develop estimates of historical inventory channel pull-through. We utilize an internal analysis to compare historical net product shipments to estimated
historical prescriptions written. Based on that analysis, we develop an estimate of the quantity of product in the channel that might be subject to various rebate, chargeback and product return exposures. At least quarterly for each product line, we
prepare an internal estimate of ending inventory units in the distribution channel by adding estimated inventory in the channel at the beginning of the period, plus net product shipments for the period, less estimated prescriptions written for the
period. Based on that analysis, we develop an estimate of the quantity of product in the channel that might be subject to various rebate, chargeback and product return exposures. This is done for each product line by applying a rate of historical
activity for rebates, chargebacks and product returns, adjusted for relevant quantitative and qualitative factors discussed above, to the potential exposed product estimated to be in the distribution channel. Internal forecasts that are utilized to
calculate the estimated number of months in the channel are regularly adjusted based on input from members of our sales, marketing and operations groups. The adjusted forecasts take into account numerous factors including, but not limited to, new
product introductions, direct communication with customers and potential product expiry issues.

Consistent with industry practice, we
periodically offer promotional discounts to our existing customers. These discounts are calculated as a percentage of the current published list price and are treated as off-invoice allowances. Accordingly, the discounts are recorded as a reduction
of revenue in the period that the program is offered. In addition to promotional discounts, at the time that we implement a price increase, we generally offer our existing customers an opportunity to purchase a limited quantity of product at the
previous list price. Shipments resulting from these programs generally are not in excess of ordinary levels, therefore, we recognize the related revenue upon shipment and include the shipments in estimating our various product related allowances. In
the event we determine that these shipments represent purchases of inventory in excess of ordinary levels for a given wholesaler, the potential impact on product returns exposure would be specifically evaluated and reflected as a reduction in
revenue at the time of such shipments.

Allowances for estimated rebates and chargebacks were $11.9 million and $3.3 million as of
June 30, 2009 and 2008, respectively. The balances exclude amounts related to Colazal, which are included in the reserve discussed below. These allowances reflect an estimate of our liability for items such as rebates due to various
governmental organizations under the Medicare/Medicaid regulations, rebates due to managed care organizations under specific contracts and chargebacks due to various organizations purchasing certain of our products through federal contracts and/or
group purchasing agreements. We estimate our liability for rebates and chargebacks at each reporting period based on a methodology of applying the relevant quantitative and qualitative assumptions discussed above. Due to the subjectivity of our
accrual estimates for rebates and chargebacks, we prepare various sensitivity analyses to ensure our final estimate is within a reasonable range as well as review prior period activity to ensure that our methodology is still reasonable. Had a change
in one or more variables in the analyses (utilization rates,

contract modifications, etc.) resulted in an additional percentage point change in the trailing average of estimated chargeback and rebate activity in 2008,
we would have recorded an adjustment to revenues of approximately $2.1 million, or 1.0%, for the year.

Allowances for product returns were
$7.9 million and $12.3 million as of June 30, 2009 and 2008, respectively. These allowances reflect an estimate of our liability for product that may be returned by the original purchaser in accordance with our stated return policy. These
balances do not include $5.9 million and $28.1 million at June 30, 2009 and 2008, respectively, reflecting our estimate of Colazal that may be returned to us under our return policy as a result of the approval of three generic balsalazide
capsule products by the Office of Generic Drugs on December 28, 2007. We estimate our liability for product returns at each reporting period based on historical return rates, the estimated inventory in the channel, and the other factors
discussed above. Due to the subjectivity of our accrual estimates for product returns, we prepare various sensitivity analyses to ensure our final estimate is within a reasonable range as well as review prior period activity to ensure that our
methodology is still reasonable. A change in assumptions that resulted in a 10% change in forecasted return rates for all products other than Colazal would have resulted in a change in total product returns liability at December 31, 2008 of
approximately $1.5 million and a corresponding change in 2008 net product revenue of less than 1.0%.

Colazal, our balsalazide disodium
capsule, accounted for a majority of the Companys revenue prior to 2008. On December 28, 2007, the Office of Generic Drugs, or OGD, approved three generic balsalazide capsule products. As a result of these generic approvals, the Company
expects the future sales of Colazal to be significantly less than historical sales of Colazal. At June 30, 2009 and 2008, respectively, $5.9 million and $28.1 million were recorded as a liability to reflect the Companys estimate of the
Companys liability for Colazal that may be returned by the original purchaser in accordance with the Companys stated return policy as a result of these generic approvals. The decrease in the liability from December 31, 2008 to
June 30, 2009 is a result of actual Colazal returns. This estimate was developed based on the following estimates:



our estimate of the quantity and expiration dates of Colazal inventory in the distribution channel based on historical net product shipments less estimated
historical prescriptions written;



our estimate of future demand for Colazal based on the actual erosion of product demand for several comparable products that were previously genericized, and the
most recent demand for Colazal prior to the generic approvals;



the actual demand for Colazal experienced during 2008 and 2009 subsequent to the generic approvals;



our estimate of chargeback and rebate activity based on price erosion as a result of the generic approvals; and



other relevant factors.

Due to the
subjectivity of this estimate, the Company prepares various sensitivity analyses to ensure the Companys final estimate is within a reasonable range. A change in assumptions that resulted in a 10% change in the quantity of Colazal inventory in
the distribution channel would have resulted in a change in the Colazal return reserve of approximately $1.1 million and a corresponding change in 2008 net product revenue of less than 1%. A change in assumptions that resulted in a 10% change in the
estimated future demand of Colazal would not have resulted in a change in the Colazal return reserve.

For the six-month periods ended
June 30, 2009 and 2008, our absolute exposure for rebates, chargebacks and product returns has grown primarily as a result of increased sales of our existing products, the approval of new products and the acquisition of products, and also as a
result of the approval of generic balsalazide capsule products. Accordingly, reductions to revenue and corresponding increases to allowance accounts have likewise increased. The estimated exposure to these revenue-reducing items as a percentage of
gross product revenue in the six-month periods ended June 30, 2009 and 2008 was 9.8% and 6.5% for rebates, chargebacks and discounts and was 6.1% and 7.9% for product returns excluding the Colazal return reserve, respectively.

The following table summarizes net product revenues for the three-month and six-month periods ended June 30 (in thousands):

Three months endedJune 30,

Six months endedJune 30,

2009

2008

2009

2008

Inflammatory Bowel Disease  Colazal/Apriso

$

(1,899

)

$



$

858

$

1,345

% of net product revenues

(4

)%

0

%

1

%

2

%

Xifaxan

26,256

18,018

50,359

34,759

% of net product revenues

50

%

44

%

52

%

46

%

Purgatives  Visicol/OsmoPrep/ MoviPrep

16,485

15,707

29,168

25,975

% of net product revenues

32

%

38

%

30

%

34

%

Other  Anusol/Azasan/Diuril/Pepcid/Proctocort

11,392

7,346

16,623

13,246

% of net product revenues

22

%

18

%

17

%

18

%

Net product revenues

$

52,234

$

41,071

$

97,008

$

75,325

Net product revenues for the three-month period ended June 30, 2009 were $52.2 million,
compared to $41.1 million for the corresponding three-month period in 2008, a 27% increase. The net product revenue increase for the three-month period ended June 30, 2009 compared to the three-month period ended June 30, 2008 was
primarily due to:



increased unit sales of Xifaxan;



increased unit sales of MoviPrep;



increased unit sales of Pepcid ; and



price increases on our products.

These increases
were partially offset by decreased unit sales of OsmoPrep, and an adjustment in the reserve for Colazal returns.

Prescription growth for
the three-month period ended June 30, 2009 compared to the corresponding three-month period in 2008 was 13% for Xifaxan and 17% for our purgative franchise. Prescriptions for MoviPrep increased 81% for the three-month period ended June 30,
2009 compared to prescriptions for the three-month period ended June 30, 2008. Prescriptions for OsmoPrep for the three-month period ended June 30, 2009 declined 41% compared to prescriptions for the three-month period ended June 30,
2008 due to the boxed warning announced by the FDA on December 11, 2008.

Net product revenues for the six-month period ended
June 30, 2009 were $97.0 million, compared to $75.3 million for the corresponding six-month period in 2008, a 29% increase. The net product revenue increase for the six-month period ended June 30, 2009 compared to the six-month period
ended June 30, 2008 was primarily due to:

sales of Apriso, which was approved by the FDA in October 2008 and launched in February 2009;



increased unit sales of Pepcid; and



price increases on our products.

These increases
were partially offset by decreased unit sales of OsmoPrep and an adjustment in the reserve for Colazal returns.

Prescription growth for
the six-month period ended June 30, 2009 compared to the corresponding six-month period in 2008 was 12% for Xifaxan and 23% for our purgatives. Prescriptions for MoviPrep for the six-month period ended June 30, 2009 increased 86% compared
to prescriptions for the six-month period ended June 30, 2008. Prescriptions for OsmoPrep for the six-month period ended June 30, 2009 declined 33% compared to prescriptions for the six-month period ended June 30, 2008 due to the
boxed warning announced by the FDA on December 11, 2008.

On December 28, 2007, the Office of Generic Drugs approved three
generic balsalazide capsule products. As a result of these generic approvals, the Company expects the future sales of Colazal to be significantly less than historical sales of Colazal. In the fourth quarter of 2007, the Company recorded a $34.6
million reserve as a reduction of net product revenues. The balance of this reserve at June 30, 2009 and 2008 was $5.9 million and $28.1 million, respectively. This reserve represents an estimate of the Companys liability for Colazal that
may be returned by the original purchaser in accordance with the Companys stated return policy as a result of these generic approvals. The decrease in the liability from December 31, 2008 to June 30, 2009 is a result of actual
Colazal returns. This estimate was developed based on the following estimates:



our estimate of the quantity and expiration dates of Colazal inventory in the distribution channel based on historical net product shipments less estimated
historical prescriptions written;



our estimate of future demand for Colazal based on the actual erosion of product demand for several comparable products that were previously genericized, and the
actual demand for Colazal experienced during 2008 and 2009 subsequent to the generic approvals;



our estimate of chargeback and rebate activity based on actual activity during 2008 and 2009 subsequent to the generic approvals; and



other relevant factors.

Due to the
subjectivity of this estimate, the Company prepares various sensitivity analyses to ensure the Companys final estimate is within a reasonable range. A change in assumptions that resulted in a 10% change in the quantity of Colazal inventory in
the distribution channel would have resulted in a change in the Colazal return reserve of approximately $1.1 million and a corresponding change in 2008 net product revenue of less than 1%. A change in assumptions that resulted in a 10% change in the
estimated future demand of Colazal would not have resulted in a change in the Colazal reserve for 2008.

Costs and Expenses

Costs and expenses for the three-month period ended June 30, 2009 were $66.2 million, compared to $47.8 million for the corresponding three-month
period in 2008, and $123.7 million for the six-month period ended June 30, 2009, compared to $105.9 million for the corresponding six-month period in 2008. Higher operating expenses in absolute terms were due primarily to increased research and
development costs, general and administrative

expenses, and increased cost of products sold related to the corresponding increase in product revenue.

Cost of Products Sold

Cost of
products sold for the three-month period ended June 30, 2009 was $11.4 million, compared with $7.1 million for the corresponding three-month period in 2008. Cost of products sold for the six-month period ended June 30, 2009 was $21.3
million, compared with $14.4 million for the corresponding six-month period in 2008. The increase in cost of products sold in absolute terms for the three-month and six-month periods ended June 30, 2009 compared to the three-month and six-month
periods ended June 30, 2008 was primarily due to the increase in net product revenues discussed above.

Gross margin on total product
revenue, excluding $2.5 million and $2.3 million in amortization of product rights and intangible assets for the three-month periods ended June 30, 2009 and 2008, respectively, was 78.1% for the three-month period ended June 30, 2009 and
82.7% for the three-month period ended June 30, 2008. Gross margin on total product revenue, excluding $5.0 million and $4.5 million in amortization of product rights and intangible assets for the six-month periods ended June 30, 2009 and
2008, respectively, was 78.0% for the six-month period ended June 30, 2009 and 80.9% for the six-month period ended June 30, 2008. Lower gross margins for the three-month and six-month periods ended June 30, 2009 compared to the
corresponding periods in 2008 are primarily due to the product revenue mix in the respective periods.

Fees and Costs Related to License
Agreements

Fees and costs related to license agreements for the three-month period ended June 30, 2008 consists of a payment of
$0.1 million for the Canadian rights to Visicol. In addition, fees and costs related to license agreements for the six-month period ended June 30, 2008 consists of a $0.5 million milestone payment to Wilmington Pharmaceuticals, and a $1.0
million up-front payment to Dr. Falk Pharma for the exclusive license to develop and commercialize Dr. Falk Pharmas budesonide products in the United States. Fees and costs related to license agreements for the three-month and
six-month periods ended June 30, 2009 consists of a $0.5 million milestone payment to Dr. Falk Pharma under the terms of our budesonide license agreement.

Amortization of Product Rights and Intangible Assets

Amortization of product rights and intangible
assets consists of amortization of the costs of license agreements, product rights and other identifiable intangible assets, which result from product and business acquisitions. The increase for the three-month and six-month periods ended
June 30, 2009 compared to the corresponding periods in 2008 is primarily a result of payments during the fourth quarter of 2008 related to the approval of Apriso, and a sales milestone payment to Norgine for MoviPrep.

Research and Development

Research
and development expenses were $22.8 million for the three-month period ended June 30, 2009, compared to $15.4 for the comparable period in 2008. The increase in research and development expenses for the three-month period ended June 30,
2009 compared to the corresponding period in 2008 was due primarily to:

reduced expenses related to our development program for our 1100mg balsalazide tablet; and



reduced expenses related to our hepatic encephalopathy development program for rifaximin.

Research and development expenses were $42.9 million for the six-month period ended June 30, 2009, compared to $41.3 for the comparable period in
2008. The slight increase in research and development expenses for the six-month period ended June 30, 2009 compared to the corresponding period in 2008 was due primarily to:

increased expenses related to the continuation of our development program for crofelemer, which we acquired from Napo in December 2008;



increased expenses related to the initiation of our development program for budesonide;



increased expenses related to investigator initiated studies; and



increased headcount costs.

These increases were
partially offset by:



reduced expenses related to our development program for our 1100mg balsalazide tablet;



reduced expenses related to our development program for granulated mesalamine, or Apriso; and



reduced expenses related to our hepatic encephalopathy development program for rifaximin.

Since inception through June 30, 2009, we have incurred research and development expenditures of approximately $70.1 million for balsalazide, $124.7 million for
rifaximin, $6.5 million for crofelemer and $37.2 million for granulated mesalamine.

Due to the risks and uncertainties of the drug
development and regulatory approval process, research and development expenditures are difficult to forecast and subject to unexpected increases. We expect research and development costs to be higher in the remaining quarters of 2009, and generally
we expect research and development costs to increase in absolute terms as we pursue additional indications and formulations for rifaximin, initiate development for the budesonide product candidate we acquired from Dr. Falk, continue the
development of crofelemer which we acquired from Napo, and if and when we acquire new products.

Selling, General and Administrative

Selling, general and administrative expenses were $29.0 million for the three-month period ended June 30, 2009, compared to $23.0
million in the corresponding three-month period in 2008. This increase was primarily due to:



expenses related to the launch of Apriso;



increased legal costs for the patent litigation related to MoviPrep and OsmoPrep; and

Selling, general and administrative expenses were $54.0 million for the six-month period ended
June 30, 2009, compared to $44.1 million in the corresponding six-month period in 2008. This increase was primarily due to:



expenses related to the launch of Apriso;



increased legal costs for the patent litigation related to MoviPrep and OsmoPrep; and



increased headcount costs.

We
expect selling, general and administrative expenses to increase in absolute terms as we expand our sales and marketing team and efforts for our current products, the launch of Apriso and potential launches of Metoclopramide-Zydis and other
indications for rifaximin, if approved. During July 2009 we began hiring an additional sales force, which will eventually consist of approximately 75 additional sales personnel in the United States.

Interest and Other Income, Net

Interest income (expense) and other income, net was $1.4 million in expense for the three-month period ended June 30, 2009, compared to $0.2 million in income in the corresponding three-month period in 2008. Interest and other income,
net for the three-month period ended June 30, 2009 consisted of:



$0.1 million of interest expense on our credit facility;



$1.5 million of interest expense on our convertible notes issued in August 2008, including $0.6 million of amortization of debt discount under FSP APB 14-1; and



partially offset by $0.3 of interest income.

Interest and other income, net for the three-month period ended June 30, 2008 consisted of:



$0.4 million of interest income; and



offset by $0.2 million of interest expense on our credit facility.

Interest income (expense) and other income, net was $2.7 million in expense for the six-month period ended June 30, 2009, compared to $0.6 million in income in the corresponding three-month period in 2008.
Interest and other income, net for the six-month period ended June 30, 2009 consisted of:



$0.2 million of interest expense on our credit facility;



$3.0 million of interest expense on our convertible notes issued in August 2008, including $1.2 million of amortization of debt discount under FSP APB 14-1; and



partially offset by $0.7 million of interest income.

Interest and other income, net for the six-month period ended June 30, 2008 consisted of:

The decrease in interest income for the three-month and six-month periods ended June 30, 2009
compared to the corresponding periods in 2008 is due primarily to lower interest rates on our investments in 2009 and lower cash and cash equivalent balances during 2009 as compared to 2008.

Provision for Income Tax

Income tax
benefit was $47,000 for the three-month period ended June 30, 2009, compared to $0.5 million in expense for the corresponding three-month period in 2008. Income tax benefit was $94,000 for the six-month period ended June 30, 2009, compared
to $1.1 million in expense for the corresponding six-month period in 2008. Our effective tax rate was 0.3% for the three-month period ended June 30, 2009, and (7.5)% in the corresponding three-month period in 2008. Our effective tax rate was
0.3% for the six-month period ended June 30, 2009, and (3.7)% in the corresponding six-month period in 2008.

Net Income (Loss)

Net loss was $15.3 million for the three-month period ended June 30, 2009, compared to $7.1 million in the corresponding
three-month period in 2008. Net loss was $29.3 million for the six-month period ended June 30, 2009, compared to $31.1 million in the corresponding six-month period in 2008.

Liquidity and Capital Resources

From inception until first achieving profitability in the third
quarter of 2004, we financed product development, operations and capital expenditures primarily from public and private sales of equity securities and from funding arrangements with collaborative partners. Since launching Colazal in January 2001,
net product revenue has been a growing source of cash. On August 22, 2008 we closed an offering of $60.0 million in convertible senior notes due 2028. Net proceeds from the offering were $57.3 million. As of June 30, 2009, we had $86.0
million in cash and cash equivalents compared to $120.2 million as of December 31, 2008. We have not encountered any material collection issues with our customers to date.

To date, the decline in the stock market, lack of credit availability and financial institution difficulties have had a limited effect on our business.
As a result of the closing of our convertible note offering in August 2008, we believe our cash and cash equivalent balances should be sufficient to satisfy our cash requirements for the foreseeable future. At June 30, 2009, cash and cash
equivalents consisted primarily of demand deposits, certificates of deposit, overnight investments in Eurodollars and money market funds at reputable financial institutions, and did not include any auction rate securities. We have not realized any
material loss in principal or liquidity in any of our investments to date. However, continued deterioration in the overall economy could impair our liquidity and/or lead to a decrease in demand for our marketed products, which could have an adverse
effect on our business, financial condition and results of operations.

Net cash used by operating activities of $32.7 million for the
six-month period ended June 30, 2009 was primarily attributable to our net loss for the period, product returns and chargebacks for Colazal, the increase in accounts receivable and the increase in inventory. Net cash used by operating
activities of $19.2 million for the six-month period ended June 30, 2008 was primarily attributable to our net loss for the period, and product returns and chargebacks for Colazal, partially offset by collection of accounts receivable for
product revenue recognized in the fourth quarter of 2007.

Net cash used in investing activities for the six-month period ended
June 30, 2009 of $1.7 million was for the purchases of property and equipment. Net cash used in investing activities for the six-month period ended June 30, 2008 of $0.7 million was primarily for the purchases of property and equipment.

Net cash provided by financing activities for the six-month period ended June 30, 2009 was $0.3 million consisting primarily of
proceeds from the exercise of stock options. Net cash used by financing activities for the six-month period ended June 30, 2008 was $0.5 million consisting primarily of principal payments on capital lease obligations.

As of June 30, 2009, we had non-cancelable purchase order commitments for inventory purchases of
approximately $25.2 million. We anticipate significant expenditures related to our on-going sales, marketing, product launch efforts and our on-going development efforts for rifaximin, our budesonide product candidates and crofelemer. To the extent
we acquire rights to additional products, we will incur additional expenditures.

Contractual interest obligations related to our convertible senior notes total $63.3 million at June 30, 2009, including $3.3 million, $6.6 million, $6.6 million and $46.8
million due in one year or less, two to three years, four to five years, and greater than five years, respectively.

(2)

Contractual interest obligations related to our credit facility total $0.7 million based on the interest rate at June 30, 2009, including $0.3 million and $0.4 million due in
one year or less and two to three years, respectively.

We enter into license agreements with third parties that may require
us to make royalty, milestone or other payments contingent upon certain future events linked to the successful development and commercialization of pharmaceutical products. Certain of the payments are contingent upon the successful achievement of an
important event in the development life cycle of these pharmaceutical products, which might not occur. If required by the agreements, we will make royalty payments based upon a percentage of the sales of a pharmaceutical product if regulatory
approval to market this product is obtained and the product is commercialized. Because of the contingent nature of these payments, we have not attempted to predict the amount or period in which such payments would be made and thus they are not
included in the table of contractual obligations.

In February 2007, we entered into a $100.0 million revolving credit facility that
matures in February 2012. On August 4, 2008 we amended the credit facility to waive defaults that might have resulted from the approval of three generic balsalazide capsule products by the Office of Generic Drugs on December 28, 2007,
and reduced the credit facility to $20.0 million. On August 22, 2008 we further amended the credit facility to allow us to issue the convertible notes described below. At June 30, 2009, $15.0 million was outstanding under the credit
facility. Virtually all of our assets and those of our subsidiaries secure our obligations under the credit facility.

The credit facility contains various representations, warranties and affirmative, negative and financial covenants customary for financings of this type. The credit facility bears interest at a rate per annum equal to, at our option, either
(a) a base rate equal to the higher of (i) the Federal Funds Rate plus 1/2 of 1% and (ii) the Bank of America prime rate, or (b) a Eurodollar rate (based on LIBOR), plus 0.00% for base rate borrowings and 1.00% for Eurodollar rate borrowings. The rate as of June 30, 2009 on
our outstanding borrowings was 1.72%. We must maintain an amount equal to the amount outstanding under the credit facility on deposit with the Administrative Agent of the credit facility and maintain a minimum of $23.0 million in cash on our balance
sheet. At June 30, 2009, restricted cash of $15.0 million represents the collateral on deposit with the Administrative Agent related to the credit facility. At June 30, 2009 we were in compliance with applicable covenants under the credit
facility.

On August 22, 2008 we closed an offering of $60 million in convertible senior notes (Notes) due 2028.
Net proceeds from the offering were $57.3 million. The Notes are governed by an indenture, dated as of August 22, 2008, between us and U.S. Bank National Association, as trustee. The Notes bear interest at a rate of 5.5% per year, payable
semiannually in arrears on February 15 and August 15 of each year, beginning on February 15, 2009. The

Notes will mature on August 15, 2028, unless previously converted or repurchased in accordance with their terms prior to such date. The Notes are senior
unsecured obligations, and rank (i) equally to any of our existing and future unsecured senior debt, (ii) senior to any of our future indebtedness that is expressly subordinated to these Notes, and (iii) effectively junior to any
secured indebtedness to the extent of the value of the assets securing such indebtedness. We may redeem the Notes, in whole or in part, at any time after August 15, 2013 for cash equal to the principal amount of the Notes to be redeemed, plus
any accrued and unpaid interest. On August 15, 2013, August 15, 2018 and August 15, 2023 or upon the occurrence of a fundamental change, as defined in the Indenture, the holders may require us to repurchase all or a
portion of the Notes for cash at 100% of the principal amount of the Notes being purchased, plus any accrued and unpaid interest.

The
Notes are convertible into approximately 6,486,000 shares of our common stock under certain circumstances prior to maturity at a conversion rate of 108.0847 shares per $1,000 principal amount of Notes, which represents a conversion price of
approximately $9.25 per share, subject to adjustment under certain conditions. Holders of the Notes may convert their Notes at their option on any day prior to the close of business on the business day immediately preceding the maturity date of
August 15, 2028 only if one or more of the following conditions is satisfied: (1) during any fiscal quarter commencing after September 30, 2008, if the last reported sale price of our common stock for at least 20 trading days in the
period of 30 consecutive trading days ending on the last trading day of the immediately preceding fiscal quarter is equal to or more than 130% of the conversion price of the Notes on the last day of such preceding fiscal quarter; (2) during the
five business day period following any five consecutive trading day period in which the trading price for the Notes, per $1,000 principal amount of the Notes, for each such trading day was less than 98% of the product of the last reported sale price
of our common stock and the conversion rate of the Notes on such date; (3) if we enter into specified corporate transactions; or (4) upon a redemption notice. The Notes will be convertible, regardless of whether any of the foregoing
conditions has been satisfied, on or after March 15, 2028 at any time prior to the close of business on the business day immediately preceding the stated maturity date of August 15, 2028. Upon conversion, we will pay cash, shares of our
common stock or a combination of cash and stock, as determined by us in our discretion.

As long as the Notes are outstanding, we are
prohibited from incurring any debt other than permitted debt, as defined in the Indenture, except that we may incur debt in certain circumstances, including meeting a consolidated leverage ratio test and a consolidated fixed charge
coverage ratio test. We may refinance our existing credit facility provided the refinanced credit facility contains substantially the same restrictive covenants with respect to financial ratios as the existing credit facility did as of
August 22, 2008.

As of June 30, 2009, we had an accumulated deficit of $181.6 million, and cash and cash equivalent balances of
$86.0 million. We expect to be unprofitable and experience negative cash flow during 2009. We believe our cash and cash equivalent balances should be sufficient to satisfy our cash requirements for the foreseeable future. Based on our current
projections, we believe that we will be able to return to a positive cash flow position without requiring additional capital. However, we might seek additional debt or equity financing or both to fund our operations or acquisitions, and our actual
cash needs might vary materially from those now planned because of a number of factors including: general economic conditions; FDA and foreign regulatory processes; the status of competitive products, including potential generics; litigation and
intellectual property risks; the actual amount of Colazal returns we receive compared to our current estimates; our ability to maintain our current credit facility; our success selling products; the results of research and development activities;
establishment of and change in collaborative relationships; technological advances by us and other pharmaceutical companies; and whether we acquire rights to additional products. If we incur more debt, we might be restricted in our ability to raise
additional capital and might be subject to financial and restrictive covenants. If we issue additional equity, our stockholders could suffer dilution. We might also enter into additional collaborative arrangements that could provide us with
additional funding in the form of equity, debt, licensing, milestone and/or royalty payments. We might not be able to enter into such arrangements or raise any additional funds on terms favorable to us or at all.

Cautionary Statement

We operate in a highly
competitive environment that involves a number of risks, some of which are beyond our control. The following statement highlights some of these risks. For more detail, see Part I. Item 1A. Risk Factors in our Annual Report on Form
10-K for the year ended December 31, 2008.

Statements contained in this Form 10-Q that are not historical facts are or might
constitute forward-looking

statements under the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Although we believe the expectations reflected in such
forward-looking statements are based on reasonable assumptions, our expectations might not be attained. Forward-looking statements involve known and unknown risks that could cause actual results to differ materially from expected results. Factors
that could cause actual results to differ materially from our expectations expressed in the report include, among others: general economic conditions; our need to return to profitability; intense competition, including from generics; the high cost
and uncertainty of the research, clinical trials and other development activities involving pharmaceutical products; the unpredictability of the duration and results of regulatory review of New Drug Applications and Investigational New Drug
Applications; the possible impairment of, or inability to obtain intellectual property rights and the costs of obtaining such rights from third parties; our dependence on a limited number of products, particularly Xifaxan and our purgatives, and the
uncertainty of market acceptance of our products; the uncertainty of obtaining, and our dependence on, third parties to manufacture and sell our products; and results of litigation and other risk factors detailed from time to time in our other SEC
filings.

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

Our purchases of raw materials are denominated in Euros. Translation into our reporting currency, the U.S. dollar, has not historically had a material impact on our financial position. Additionally, our net assets denominated in currencies
other than the U.S. dollar have not historically exposed us to material risk associated with fluctuations in currency rates. Given these facts, we have not considered it necessary to use foreign currency contracts or other derivative instruments to
manage changes in currency rates. However, these circumstances could change.

Item 4.

Controls and Procedures

Disclosure controls and
procedures (as defined in Exchange Act Rule 13a-15(e)) are designed only to provide reasonable assurance that information to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified
in the SECs rules and forms and accumulated and communicated to the issuers management, including its principal financial officer, or persons performing similar functions, as appropriate to allow timely decision regarding required
disclosure. As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our President and Chief Executive Officer and Executive VP, Finance and
Administration and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, our President and Chief Executive Officer and Senior VP, Finance and
Administration and Chief Financial Officer have concluded that our disclosure controls and procedures are effective to provide the reasonable assurance discussed above.

There was no change in our internal control over financial reporting in the quarter ended June 30, 2009 that materially affected, or is reasonably likely to materially affect, our internal control over financial
reporting.

From time to time, we are party
to various legal proceedings or claims, either asserted or unasserted, which arise in the ordinary course of business. Management has reviewed pending legal matters and believes that the resolution of such matters will not have a significant adverse
effect on our financial condition or results of operations.

We are involved in a lawsuit against a company seeking FDA approval to market
a generic version of our MoviPrep product. Norgine, B.V. and Norgine Europe, B.V. own U.S. Patent No. 7,169,381 (the 381 patent). The 381 patent is listed with the FDA as protecting our MoviPrep product. Norgine licensed MoviPrep
and the 381 patent to us for commercialization in the United States. Novel Laboratories, Inc., filed an Abbreviated New Drug Application, or ANDA, with the FDA seeking approval to market a generic version of MoviPrep in the United States prior
to the September 2024 expiration of the 381 patent. On May 14, 2008, we and Norgine filed a lawsuit in the United States District Court for the District of New Jersey against Novel for infringement of the 381 patent. Novel filed an
Answer and Counterclaims on June 20, 2008. On June 25, 2009 we and Norgine amended the complaint to add a claim for correction of inventorship for the 381 patent. Novel has denied infringement and asserted various affirmative
defenses, including defenses of patent invalidity and unenforceability. No trial date has been set. We intend to vigorously defend the patent rights for MoviPrep.

We are also involved in a lawsuit against Novel because Novel is seeking FDA approval to market a generic version of our OsmoPrep product. CDC, LLC, owns U.S. Patent No. 5,616,346 (the 346 patent). The
346 patent is listed with the FDA as protecting our OsmoPrep product. CDC, by its predecessor, licensed OsmoPrep and the 346 patent to us for commercialization in the United States. Novel filed an ANDA with the FDA seeking approval to
market a generic version of OsmoPrep in the United States prior to the May 2013 expiration of the 346 patent. On September 8, 2008, we filed a lawsuit in the United States District Court for the District of New Jersey against Novel for
the infringement of the 346 patent. The lawsuit also joins CDC as a party. Novel filed an Answer and Counterclaims on December 16, 2008. Novel denied infringement and asserted a defense of patent invalidity. No trial date has been set. We
intend to vigorously defend the patent rights for OsmoPrep.

On or about July 14, 2008, Strides Arcolab Limited filed a Citizens
Petition with the FDA seeking permission to submit an ANDA for change of dosage form from tablet to capsule for a 200mg generic version of Xifaxan. We intend to vigorously enforce the regulatory and intellectual property rights regarding Xifaxan. We
are unable to predict the outcome of any ensuing regulatory action or litigation at the present time.

Regulatory data exclusivity for
Xifaxan 200mg tablets ended on or about May 24, 2009. Accordingly, the Office of Generic Drugs would have been able to accept an ANDA for Xifaxan tablets on or any time subsequent to May 24, 2008, if the applicant certified that its
generic rifaximin does not infringe Salixs patent. If this occurred, a Paragraph IV notification would have to be provided to us by the applicant. Although we do not possess any specific knowledge of any such filing at the current time, the
expiration of data exclusivity could result in a challenge to the related intellectual property rights of Xifaxan 200mg tablets at any time in the future. We intend to vigorously enforce the patent rights for Xifaxan.

Our 2009 Annual Meeting of Stockholders was held on June 18, 2009. The following is a brief description of each matter voted upon at the meeting and a statement of the number of votes cast for, against or withheld and the number of
abstentions with respect to each matter.

(a)

The stockholders elected the following directors to serve for the ensuing year and until their successors are elected:

FOR

WITHHELD

John F. Chappell

40,808,385

484,833

Thomas W. DAlonzo

41,006,094

287,124

Richard A. Franco, Sr.

40,854,057

439,161

William P. Keane

40,870,690

422,528

Carolyn J. Logan

41,027,187

266,031

Mark A. Sirgo

40,871,681

421,537

(b)

The stockholders approved the amendment of our 2005 Stock Plan to increase the number of shares of common stock reserved for issuance thereunder from 3,900,000 to 5,900,000:

FOR

AGAINST

ABSTAIN

BROKERNON-VOTES

34,015,996

2,278,658

21,514

4,977,050

(c)

The shareholders ratified the appointment of PricewaterhouseCoopers LLP as our independent auditors for the fiscal year ending December 31, 2009.

FOR

AGAINST

ABSTAIN

41,185,974

66,825

40,419

Item 5.

Other Information

Under the terms of our License
and Supply Agreement with the Debiopharm Group, on August 4, 2009, we provided a 30-day notice to Debiopharm of termination of the agreement because the FDA did not approve Sanvar.

Certification by the Chief Executive Officer pursuant to Section 240.13a-14 or Section 240.15d-14 of the Securities and Exchange Act of 1934, as amended.

X

31.2

Certification by the Chief Financial Officer pursuant to Section 240.13a-14 or Section 240.15d-14 of the Securities and Exchange Act of 1934, as amended.

X

32.1

Certification by the Chief Executive Officer pursuant to 18 U.S.C. 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

X

32.2

Certification by the Chief Financial Officer pursuant to 18 U.S.C. 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

X

*

The registrant has requested confidential treatment with respect to portions of this exhibit. Those portions have been omitted from the exhibit and filed separately with the U.S.
Securities and Exchange Commission.